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Monday November 21, 2005 - 11:17:53 GMT
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UK economic data suggest interest rates will stay on hold

Economics Weekly: Economic Research and Analysis : UK economic data suggest interest rates will stay on hold

November - a month of weak economic data?
With most of the UK’s main economic data releases for November now released, it may be worth briefly summarising their implications for the economy and what they may mean for the direction of short term interest rates, remembering that the repo rate was left at 4.5% at the November 2005 Monetary Policy Committee (MPC) meeting.

It is worth starting with the view that the financial markets took of the data that were released in the month, including the Bank of England’s Inflation Report. This view can be discerned from the bets that are placed on where short term interest rates are going to be – the short term sterling futures contract. As chart A shows, the financial markets are now implying that short term interest rates could be cut in 2006, whereas at the start of the month they were not. What about our view of the data?

UK interest rates on hold into 2006...
Since the vote to keep interest rates unchanged at the October MPC meeting was unanimous, it was not a major surprise that they were left untouched at the subsequent meeting. However, the market view, as shown by the futures contract for short term sterling borrowing, is that base rates could still be cut in 2006, with the most likely time put at May 2006, when an Inflation Report is due. The MPC has not cut interest rates this autumn as was aggressively expected by the financial markets only a few months because they were worried that above target inflation, fuelled by high oil prices, would feed into wage inflation and so cause a wage-price spiral (but no signs of this, see chart B). Moreover, there were also some tentative signs that economic growth was beginning to recover, with retail sales off its lows, money supply growth accelerating and the housing market improving, see chart C.

...Bank of England revises down forecasts
The Bank of England Inflation Report for November revised down growth and inflation over the next 2 years. Our view on the Inflation Report is that it is therefore more dovish than the previous one, which was in August. The pattern of inflation that the Bank of England expects to see is for it to remain above its 2% target in the near term, fall below by about mid 2006, before rising back to 2% in 2 years’ time. The main downside risk to growth is if consumer spending and investment spending do not pick up as expected. For inflation, the report expects the unwinding of the recent rise in energy costs to push it lower in mid 2006, but the MPC is concerned about the reaction of wages to the recent above target rise in consumer price inflation. As yet, however, there are few signs that wage inflation is reacting strongly. The MPC did hint that an increase in migrants from the new EU countries may have helped to keep down wage inflation, so should economic growth pick up as expected in 2006 and migrant flows do not pick up then wage inflation could rise more strongly. Overall though, the bank judged that: ‘the risks to growth and inflation are broadly balanced.’

However, price inflation remains above target. There was a fall in annual consumer price inflation (CPI) in October to 2.3%, the first fall in over a year, taking the annual rate back to the same level as in July and down from 2.5% in September. In the month, the fall was due mainly to lower seasonally food prices. Energy prices were also down, with a litre of fuel costing less this year than 12-months ago. Core consumer price inflation, which excludes, food, drink and tobacco rose by 0.1% but the annual rate eased back to 1.6% from 1.7% in September, as overdraft costs were lower this year than a year earlier. This may have been down to lower interest rates rather than a general reduction of core inflation pressure in the economy, but still suggests that there are price reductions taking place. However, goods and services price inflation do not suggest that inflation is about to fall back; services price inflation is about 4.5% a year and goods prices are now rising (by 0.6% a year), rather than falling as they were a few months ago.

…amid signs of housing market improvement..
The British Bankers’ Association (BBA) reported that net mortgage lending slowed to £4.3bn in October compared with £4.7bn in September. Gross lending also fell back according to the Council of Mortgage Lenders (CML). However, although the data are weaker than expected, it must be put into context with the fact that the recent numbers had been particularly strong and some normalisation had to be expected. In addition, neither the BBA nor CML data are seasonally adjusted. The underlying fact remains that the housing market is showing strong signs of stabilisation, reflected in house prices, lending, approvals, transactions and inquiries data. The BBA numbers also showed higher credit card lending than usage of personal loans and overdrafts, maybe reflecting the pick up seen in retail sales numbers recently; this should see BoE consumer credit numbers also come in stronger in October after being subdued in recent months. The M4 money supply numbers also proved stronger than expected, rising by 1.1% in October, an annual rate of 11.6% from an upwardly revised 11.2% in September. The strength of these numbers only further highlights the sheer extent of liquidity available in the UK financial system and question whether price inflation will slow down over the medium-term and suggest that conditions are favourable for economic growth to pick up quite sharply in coming quarters.

...and economic growth has stabilised
UK retail sales volumes rose 0.2% in October, slower than the revised lower 0.6% pace in September but in line with the market median estimate. The annual rate also accelerated to 1.5%, in line with expectations and rebounding after slowing to a nine year low of 0.7% in September. In addition, the three month on three month growth rate of retail sales improved to 0.7% from 0.4% in September, reflecting an increase in non-food retail sales. The intensity of competition on the high street continues to see price discounting used as a significant means of ensuring volume growth, with the latest data showing that the implied deflator for October was minus 1.1%, the biggest fall since February. If we look at the value of retail sales at today’s prices in October compared with October 2004, they were up by just 0.3%. But they were underpinned by 3% growth in food store sales; the greater challenge is seen in predominately non-food stores sales, which were down 1% over the same period.

A further cut interest in rates now seems unlikely in the short term with economic growth trends in November looking slightly more robust in recent weeks. Notably, PMI indicators for both manufacturing and services rose in October, to 51.7 and 56.1 respectively. If these levels are improved on further or even if they are just maintained in the final months of the year, it would imply UK economic growth in Q4 2005 could rise by 0.5%, up from 0.4% in Q3.

UK economic indicators
There are very few figures out this week, but attention will be on the ODPM house price data on Monday, where signs of stabilisation in the building society data should mean a small rise in the annual rate is possible. Second estimates of Q3 gdp data, due on Friday, and CBI industrial trends, due on Tuesday, are likely to show some improvement in the latter but no revisions, yet, despite MPC misgivings, to the former.

Trevor Williams, Chief Economist
[email protected]
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.


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